Embedding an NPV Analysis into a Binomial Tree with a Real Options Application

26 Pages Posted: 24 Feb 2020

See all articles by Tom Arnold

Tom Arnold

University of Richmond - E. Claiborne Robins School of Business

Timothy Falcon Crack

University of Otago - Department of Accountancy and Finance

Adam Schwartz

Washington and Lee University - Department of Business Administration

Date Written: January 22, 2020

Abstract

Financial statements and an accompanying NPV calculation are embedded into a binomial tree. This generalization of traditional static NPV analysis allows the financial statements to both evolve through time and, at any given time, to vary with states of the world (similar to a Monte Carlo analysis). Modelling the component cash flows in a tree reveals dynamic detailed structure, leading to a more useful NPV analysis than if only the final cash flow value was modelled in a tree or if component cash flows were modelled without a tree. This dynamic detail provides credible cash flow forecasts that can improve hedging of adverse events and allow for leveraging of beneficial circumstances. The financial statements take the form of pro forma after-tax operating cash flows in this treatment. However, any cash flow model driven by the random variable in the tree and allowing for separate treatment of fixed costs, can be used. The benefits of this technique are illustrated via a real options example.

Keywords: Real option, Binomial tree, embedded NPV analysis

JEL Classification: G30, G31, G32, G13

Suggested Citation

Arnold, Thomas M. and Crack, Timothy Falcon and Schwartz, Adam, Embedding an NPV Analysis into a Binomial Tree with a Real Options Application (January 22, 2020). Available at SSRN: https://ssrn.com/abstract=3526901 or http://dx.doi.org/10.2139/ssrn.3526901

Thomas M. Arnold (Contact Author)

University of Richmond - E. Claiborne Robins School of Business ( email )

102 UR Drive
University of Richmond, VA 23173
United States
804-287-6399 (Phone)
804-289-8878 (Fax)

Timothy Falcon Crack

University of Otago - Department of Accountancy and Finance ( email )

Dunedin
New Zealand

Adam Schwartz

Washington and Lee University - Department of Business Administration ( email )

Lexington, VA 24450
United States

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